The importance of having a financial cushion

The management of personal finance is essential for planning the future and to have access to a better quality of life. It is precisely for this reason that building up a so-called financial cushion allows for financial autonomy and stability in the household economy.

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The so-called “financial cushion” is a savings technique whose main purpose is to build up an emergency fund to cover unforeseen expenses and maintain relative financial autonomy. However, it can also be used to invest in specific projects or to cover other expenses in case our income is affected for any reason.

What is a financial cushion?

The financial cushion is a type of financial tool that is generated within the household economy to avoid indebtedness in the event that our income is insufficient to meet any expense or interruption in income. This fund is generated from the gradual saving of the person according to his or her income and saving capacity.

Regarding savings, the latest data available from the Quarterly Non-Financial Accounts of the Institutional Sectors report of the Spanish National Statistics Institute (INE) for the last quarter of 2022, at present the average savings rate is at 14.5% of household disposable income. This represents a reduction of 7 points with respect to 2021.

However, the financial cushion must anticipate these macroeconomic circumstances. Although it should be used for expenses that are not foreseen in our budget, once it is set up, it is often used for other purposes – a holiday, the purchase of a household appliance, investment in a professional project. However, it is advisable to use it only in cases of urgency.

How to build up a financial cushion?

Acquiring a financial cushion is relatively simple. In order to fulfill its function, it must exceed a minimum that is calculated on the basis of the household’s monthly income and expenses. It should cover between three and six months of total household expenses. It is therefore up to each individual case to determine the minimum amount.

According to data from the INE report, household final consumption expenditure increased by 12 % over the previous year, with households devoting a higher percentage of income to consumption. This phenomenon can be attributed to the inflationary scenario and the fall in purchasing power that this produces.

To acquire it, the household’s average cost of living must be weighted to determine a specific amount that can be contributed month by month, depending on the capacity of the budget to build up this fund. Once a fund sufficient to cover three to six months of expenses is reached, the cushion is built up.

We’ll show you better with a visual example:

Example of building a financial cushion

Suppose a person with a salary of 1200$ wants to build a financial cushion to be able to cope with unforeseen events.

  1. The first step is to determine the average cost of living of the household, i.e., how much is spent on average each month on essential expenses such as food, housing, transportation, bills, etc. Let’s say this person’s average household cost of living is 800$ per month.
  2. The next step is to determine what specific amount can be contributed month by month to the cushion fund. To do this, it is important to analyze the personal budget and determine how much can be contributed each month without jeopardizing the financial balance. Let’s say this person decides to contribute 100$ per month to the cushion fund.

Therefore, after 2 years (24 months) of contributing 100$ per month to the financial cushion, this person will have accumulated enough money to cover his essential expenses for 3 months. If he/she wants a more robust cushion to cover up to 6 months of expenses, he/she will need to continue contributing money until he/she reaches 4800$ (6 x 800$), which would take an additional 24 months (2 years).

How long does it usually take to acquire a financial cushion?

Depending on the household’s income, expenses and the minimum amount of the fund, it may take more or less time to build up a financial cushion. It should be noted that the constitution of this fund, as such, does not require that this amount be reached immediately.

Thus, depending on our age and financial intentions, it may take about two years of dedicating this percentage of income to the emergency fund to reach the required amount. For younger age groups, it is recommended that a higher percentage of income be contributed and then conserved, reinstated, and reduce this contribution over time.

Generally, a conservative average for contributing to such an emergency fund is 10-15% of monthly income until the desired amount is reached. Of course, the effectiveness of this model depends on the individual’s profile and ability to save.

How does microsavings benefit building a financial cushion?

Based on the previous section, it is understood that microsavings are essential to build up a financial cushion. As an emergency fund, it does not necessarily have to be immediately available, so small contributions are the best way to build it as such.

In this respect, in addition to specific monthly contributions, money left over from income can be used to build up this fund. The same can be said for regular expenses that result in a surplus from consumer purchases, services and refunds for promotions, discounts and other commercial benefits.

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Building your financial cushion through automatic and personalized savings

Today, due to the IT solutions developed for online banking and payment applications, building up a financial cushion is easier than ever. Indeed, such tools make it possible to automate savings based on expenses and commercial benefits mentioned above.

Digital banking applications and platforms enable people to distribute money and build up a savings fund. The surplus of monthly income from personal consumption and other payments will be deposited in it.

In addition, these types of applications offer different types of savings tools to generate monthly passive income to enlarge the financial cushion.

Acquiring a financial cushion is essential for our autonomy and economic stability. However, its creation depends on the profile of the individual, his or her long-term objectives and the saving capacity at his or her disposal.

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